How to set up and when to use your emergency fund

Dear Dr Pesa,

I had a lucrative job before the pandemic but I unfortunately got the axe as an effect of COVID-19. I have since gotten a new job with significantly less pay, Sh30,000 per month. I don’t want to experience the same trauma I did for the past three month in the cold. Please advise on how I can set up an emergency fund and more importantly, what can I use it on and what should I not spend it on?

David.

Dear David,

I am sorry about the job loss you experienced as a result of the COVID-19 pandemic but I am glad you have since found another job.

To begin with, an emergency fund as the name suggests, is a financial safety net that is normally set aside for emergencies/ unexpected expenses. Think of it as your SOS fund should anything go wrong. Emergency funds should be easily accessible and should cover at least 3 months of your expenses. Key to note, these expenses should be inclusive of your rent, transport, utilities, etc.

Having an emergency fund will not only give you the confidence that you can handle any unexpected life events, but also keeps you from spending on impulse as well as making bad financial decisions.

Here are some of the tips of setting up an emergency fund;

1. Determine the amount you want to save

The key to setting up an emergency fund is starting early. Before setting up an emergency fund, you can calculate your monthly expenses for at least 3 months and make that your target for the emergency fund.

For example, if your total monthly expenses amount to Sh3,000, you will need Sh9,000 as an emergency fund to cover your 3 months expenses and Sh18,000 to cover your 6 months expenses. You can make this your emergency fund target.

2. Budget

Having a budget is the best way to track how much you can set aside to go towards your emergency fund. Create a budget that accounts for the emergency fund. The amount set aside should be an amount that does not strain your pockets.

What I mean is, set aside an amount that you are most comfortable with. Maintaining a scaled back monthly spending will ensure you have room in your budget to build your emergency fund.

3. Slash the unnecessary expenses on your budget

I know that at times we feel the need to fulfil our lifestyles (expensive phones, daily take-outs, etc.) which in most cases are not really necessary. It is important to remember that you should not spend on luxurious items just because you think that that’s the life you should be living. Living within your means is a sure way of having that extra coin go towards your emergency fund.

To put it to perspective, if you eat take outs every day and you have noticed that it has been straining your budget, you can reduce the amount of times you eat take-out and channel that extra cash towards your emergency fund.

Additionally, setting aside the emergency fund and forgetting about it will enable you to resist the urge to spend the money that you have since saved.

4. Assess and readjust your monthly contributions

It is important to assess your emergency fund after a few months so as to know how much you have saved. This will also enable you to know whether you need to adjust it. Monitor your emergency fund periodically to ensure that it is always at optimal levels. If there is a change in your financial situation, reevaluate your emergency fund to cater for the changes. This will ensure that you are maintaining a healthy fund in the long run.

Given that emergencies can strike at any time and without warning, it is important to place the funds in an investments asset class that offers you easy access to your funds and generates high returns as well. One should weigh the options available to them and make an informed decision that will enable them reach their goal. For instance, you can place the funds in a high yielding savings account, a money market fund account etc. Key to note, this account should be different from your bank account so that you are not tempted to use it.

Don’t spend it here:

Emergency funds should not be used for impromptu purchases.

Regular spending such as wardrobe upgrades should always be funded using your income and not your emergency fund.

Given that there are some bills that can come up and will at that time feel like an emergency, it is important to determine whether it is absolutely necessary to spend the money.

As you build your budget, it is key to note and budget for all upcoming expenses such as a friend’s birthday present, back to school shopping … so as not to tap into your emergency fund when that time comes.

Use It here:

What is your emergency fund really for then?

You can tap into your emergency fund for items such as living expenses after a job loss or after a reduction in your income, emergency home repairs, emergency / necessary medical expenses etc. Key to note, if the circumstance necessitates you to tap into your emergency fund, you should therefore adjust your spending habits to allow for maximum utilization of the funds.

After utilizing your emergency fund, replenishing it afterwards is key to ensuring that you have funds for the next time you are in need. You can never be sure what life will throw your way but being financially prepared through an emergency fund is one way to cushion yourself against such uncertainties.

Dr Pesa is Anne Wacera (pictured), an Investments Analyst at Cytonn Investments.